Looking Back at '08, When the Unthinkable Suddenly Wasn't

It was one of the most tumultuous years in the history of the municipal bond market for tax-exempt portfolio managers.

The collapse of the bond insurance industry and the auction-rate market, the contraction of Wall Street and the banking industry, the severe liquidity crisis, and the worsening recession - 2008 was a year that many would like to forget.

Not only did portfolio managers have to constantly examine the underlying credit of their holdings, but they also had to invest cash in the midst of a highly volatile market plagued by ongoing financial and economic turmoil.

Triple-A bond insurance completely lost its luster, while the spread relationship between 30-year, triple-A municipals and U.S. Treasuries steadily crept into unprecedented territory. Although the ratio hovered at 164% last week, that was down from its recent highs of over 200% in December.

The Bond Buyer recently asked six portfolio managers to discuss 2008's major challenges and share some predictions for 2009.

Phil Condon, managing director at Deutsche Asset Management in Boston, manages $7 billion in municipal assets:"It has been a year of historic changes. We have seen a transformation from an arbitrage, institutional account-driven market to a retail-driven market. You had a change in the major players and anytime you have a change like that you go from a relative value-driven market to an absolute yield-driven market.

"One of the lessons we learned was how leveraged the high-grade municipal market was and how important the hedge funds were. They provided a lot of liquidity in the market and now they are gone.

"We are back to being a retail buyer market - individuals buying either directly or into mutual funds are the key players where a year ago the hedge funds and arbitrage accounts were the key players.

"There was also a change in the institutional market-makers. The loss of Bear Stearns and major changes at Lehman and Merrill has negatively affected the liquidity of the municipal market. Even the amount of money that brokers had to put in municipals was definitely restricted in 2008.

"As a result, there is something to be said for the new year starting. The housing market has been paralyzed, so it's a new season for the potential for home sales to pick up, there's a lot of anticipation for attractive federal mortgages, and the new administration coming in, so there is some hope.

"In 2009, I think you are going to see a lot of interest in municipals, and a lot of cash going into tax-exempt mutual funds. The natural high-quality and attractive yields will fit well with investors' desire for yield without a great deal of risk."

Reid Smith, principal and portfolio manager at Vanguard Inc. in Valley Forge, Pa., manages long-term and high-yield funds totaling $11 billion:"It was all about liquidity in 2008. There was high dependency on financial guarantors to enhance credit quality, and when the insurance fell away, municipal market leverage began to collapse.

"There was also a lot of imbedded leverage in our industry that was facilitated by the over-reliance on financial guarantors. Internal leverage and a low-quality bias were two factors that penalized funds.

"If you were high-quality biased and did not use leverage, you fared better. In 2008, there was a liquidity crunch. Pretty much everything was dragged down, and the yields increased because too many people headed for the exit.

"In 2009, we have to pay attention to credit. The quality of issuers is going to come under pressure from weakness in revenues and financial shortfalls. The real job of portfolios is managing credit concerns. It's going to take good credit processes and more selective buying to find opportunities in 2009."

Dan Loughran, portfolio manager at OppenheimerFunds Inc. in Rochester, N.Y., whose team manages 18 municipal bond funds that totaled $22 billion as of Nov. 30:"It was a year unlike any we have seen in the municipal market - especially for the high-yield sector. Usually in flight-to-quality situations, which is what the global financial markets had been in the last 18 months, high-grade municipal bonds move in the same direction as Treasuries.

"What was completely different this time is the fact that even though the prices of Treasury bonds increased dramatically, the prices on high-grade municipals had fallen significantly.

"Because of the fear associated with the credit crisis, the further away from natural triple-A, the worse the market was, and the greater prices fell, the thinner liquidity became.

"The number of actual defaults in the municipal market still remains extremely low so that when market conditions improve, prices on lower-rated bonds have more upside because they have fallen more than high-grade municipals.

"We have been selling pre-refunded bonds, which have held up very well, and buying lower-credit quality bonds, which offer far more yield and more price upside. You can get more absolute yield for the tax-exempt version of a bond than the taxable, corporate component of the same credit.

"There's so much fear and apprehension in all financial markets that eventually the giant pools of capital will tire of earning paltry returns on Treasuries and money markets, and the municipal market will be one that will attract capital in 2009."

Tom Dalpiaz, first vice president and portfolio manager at Advisors Asset Management in Melville, N.Y., where he manages mostly separate bond portfolios for high-net-worth retail investors in 25 states totaling $125 million:"I have been in municipals for 26 years, and I have never seen a year like 2008. It was the year the municipal market changed fundamentally. There was not one shoe that dropped, but a series of shoes dropping. It was a revolving roller coaster of fear reappearing in the market.

"One of the lessons we learned was that in 2008 the unthinkable was thinkable - the disintegration of insurance and the disappearance of nontraditional buyers. Bond insurance was seriously questioned and actually devalued in nearly every case - except for Berkshire Hathaway. That was a fundamental change. It means retail had to look to the underlying credit.

"There were two times where the long end had a real difficulty operating - in late February-early March and in September-October - and the bid-side just crumbled on the long end. It was the year when all my convictions about why the long end doesn't work for retail investors were verified 20 times over.

"We lost a lot of municipal players that I think hurt the long end. There were a couple of municipal trading desks not taking down positions, and fewer players on the long end.

"We found value and were selectively aggressive, but kept our philosophy of focusing on the intermediate range and investment-grade approach - even when the long end was ridiculously cheap. We added some single-A rated uninsured paper, and some triple-B paper, and that served us well.

"We are going to stay with our investment approach. You have to continue that careful stewardship of people's funds - even at a time when people want to put cash in a mattress. In 2009, for us it's all about being consistent. There is great fear and you have to be vigilant, but there is opportunity out there."

Paul Toft, a portfolio manager at Victory Funds in Columbus, Ohio, whose team manages over $1 billion in municipal assets:"One of the two biggest events in 2008 was the deterioration of monoline insurers and the total disconnect of municipals to Treasuries. Typically, municipals would lag Treasuries and the ratio on the long end is historically 95%.

"One of the problems for both dealer desks and hedge funds was that it was next to impossible to hedge a municipal position because there was nothing to short against it that was a good correlation, and that led to poor liquidity.

"One of the lessons of 2008 was we learned that things can get worse and can get cheaper in terms of price. In 2009, there will be extreme cautiousness. There are a lot of bonds in the pipeline, and some buyers, like hedge funds, taken out of the market. That leads to a challenging environment for the market to absorb a lot of new-issue supply.

"We will have to see how the market is valuing different types of wraps or insurers and try to be on top of an evolving situation of what kind of credits there is broad demand for. You can't afford to buy everything that looks cheap.

"I don't think we'll turn the page and say its 2009 now and it's a new year and we can start fresh. We ended on an illiquid note and it's unlikely that will just fix itself the first few weeks of January."

Rich Ciccarone, managing director at McDonnell Investment Management LLC in Oakbrook, Ill., which manages nearly $6 billion in separate accounts for high-net-worth retail investors and institutions:"Going into the new year we believe deflation is more likely than inflation, and our investors think the long end is going to be the most dynamic.

"There will be a commitment to a double-barreled credit analysis. We look at insurance as double-barreled and that concept is going to be reinforced in 2009 and 2010. Credit is going to be king through 2009.

"The market has lumped a lot of good credits with weak credits. Investors will have to sort out strong and weak credits with the help of investment professionals. To that extent, you will see some efficient market pricing that will play itself out.

"Strategies in 2009 will include comparing municipal ratios to corporate ratios rather than Treasuries because there has been such a flight to quality on Treasuries it has distorted the normal ratios.

"The first quarter will be eventful because the promises made by the new administration will be spelled out and the market will interpret the long-term implications for the marketplace and that could cause significant movement in the Treasury ratios.

"There is a lot of volume waiting in the wings. Retail itself is going to be much more careful in balancing portfolios. For portfolio management, I would expect to see municipals as a higher concentration in asset allocation relative to equities than in years past."